Friday, May 21, 2010

There He Goes Again

I shouldn't read Krugman's New York Times column, as sloppy thinking irritates me. I made that mistake this morning though. Krugman is in doom-and-gloom mode again. Apparently Paul thinks that we're potentially headed for the Japanese 1990s experience. Here's his take on the latest CPI report:

This isn’t really surprising: you expect inflation to fall in the face of mass unemployment and excess capacity. But it is nonetheless really bad news. Low inflation, or worse yet deflation, tends to perpetuate an economic slump, because it encourages people to hoard cash rather than spend, which keeps the economy depressed, which leads to more deflation. That vicious circle isn’t hypothetical: just ask the Japanese, who entered a deflationary trap in the 1990s and, despite occasional episodes of growth, still can’t get out. And it could happen here.

We're in the midst of what's looking like a strong recovery, and Krugman makes it sound like the midst of the Great Depression. At the moment, we should be anticipating that the returns on lending are going to start to look very good for banks, and they will lose interest in holding reserves, at which point we get some more serious inflation. This will necessitate some monetary tightening, i.e. an increase in the interest rate on reserves. At this point, though, the Fed should just hang tight, and sell their MBS and agency securities while the prices are high.

There is certainly reason to be concerned about what is going on in Europe. There is panic at large, and we don't need to be reminded that panics don't just happen in some of our models. In this case though, I think the Greek crisis is not a big deal on a world scale. Hopefully in a few weeks everyone will regain their senses, and asset prices will be back where they were - I could be wrong though.

This is a first for me. I am usually pleased to get comments - it tells me what is confusing people, and forces me to defend what I'm writing. People often come up with interesting bits of information that help us all learn about these topics. However, I had three comments from "anonymous" above, which I would characterize as abusive. I know I pick on Krugman, but I think someone has to do it. In future, I will be glad to hear from you as long as you state your point of view in a courteous way. In the "comments" section we treat each other respectfully. If not, I'll be happy to delete you.

Just to show how fair I am, I deleted Andolfatto's comment too. David, you're not allowed to call anyone a "pinhead." David actually calls me "pinhead" on a daily basis, but I won't let him refer to others as pinheads in my respectful blog space.

Stephen,I sense that it is you that is confused about banks excess reserves (BTW- this is not coming from a Krugman fan; Krugman doesn't understand anything to bank excess reserves...).

Again... aggregate level of reserves does not say anything on banks willingness to lend. In fact, these excess reserves may be changing hands as we speak. Furthermore, if the Fed would have sterilised all its purchase of MBS, Banks would be holding T-bills instead of excess reserves... do you seriously think that T-Bills constitutes a "barrier" to bank lending? There is no difference whatsoever from a private bank perspectives between holding excess reserves or T-Bills.

If you don't worry about banks holding T-bills, why on earth would you worry about banks holding excess reserves???

1. It is certainly true that we can think of reserves as essentially identical to T-bills under the current circumstances. Thus, if the Fed conducts an open market operation, swapping one asset for the other, it essentially makes not difference.2. What does make a difference in the current regime is changing the interest rate on reserves. Increasing it increases the willingness of banks to hold reserves, and the price level falls.3. It's not the excess reserves that is the problem at all. That's not what I said. Some people seem confused about where the inflation will come from, as I've discussed in other posts. Where it comes from is banks attempting to substitute between reserves and loans when lending starts looking more attractive. Of course something has to change for that to happen - it's not like the reserves somehow spontaneously cut themselves loose.4. You might tone down your language a bit - no need to call me confused or imply that I'm stupid. "Why on earth?" and ??? aren't necessary. I understand what you're saying without that stuff.

I call myself a pinhead on almost a daily basis too! Anyway, you deleted the main point of my message, which was: keep up the great work...I'm learning a lot from your blog and the comments that (most) people post.

Steve:With all due respect, you set the tone of the discussions in the first place by calling Paul Krugman's ideas "sloppy thinking" and his work "non sense", not me. You are throwing some political punches (just as Paul Krugman is in the NYT), you have to expect you will receive some (just as Paul Krugman should expect to receive some as well). In any case, your arguments against Paul Krugman's work would be improved if you leave aside insults. Changing the tone of my emails would also improved my economic arguments, so I agree to changing my tone.

Back to economics... 1)Fed has no choice but to pay interest on excess reserves corresponding to the target rate otherwise reaching the target rate would be impossible. 2) Excess reserves is immaterial to private banks decision to lend. Granting loans remains, and have always been, a decision about risk/return trade off. It has nothing to do with the desire the substitute between reserves and loans.

1. I try to stick to ideas. As I stated once before, I don't have anything personal against Krugman at all. Nothing I've said about his ideas has anything to do with politics. In fact I'm sure that Krugman and I vote exactly the same way. But if I think that Krugman's ideas are sloppy, I can say so, and that is not insulting him personally. It's the ideas, not the guy.

2. Under the current regime (positive excess reserves) it's the interest rate on reserves that is the relevant policy rate. The "target rate" cannot be set independent of the interest rate on reserves - if arbitrage were perfect and interbank lending were risk-free, the interest rate on reserves and the interbank rate have to be the same when positive excess reserves are held.

3. A bank chooses a portfolio of assets based on the characteristics of the assets it is choosing among. If something changes in how banks view the payoff distribution on lending, that has to change its willingness to hold all the other assets in its portfolio, including reserves.

1) "A bank chooses a portfolio of assets based on the characteristics of the assets it is choosing among." Agreed. This is the risk/return assessment. 2) "If something changes in how banks view the payoff distribution on lending, that has to change its willingness to hold all the other assets in its portfolio, including reserves."No, banks can perfectly accommodate more loans and sticking to their excess reserves. We are not in a fixed money supply world. The supply of money is endogenous. In our economy, “money supply” is demand-determined (if demand for credit expands so does the money supply). As credit is repaid the money supply shrinks. The money supply, for example M3 (which is shrinking big time right now) is just a reflection of the credit circuit.

He's writing largely to persuade the general public for what he thinks is the greater good. I mean this is a popular column with a strict short word limit. He has to keep it crisp and undry, which can result in vague, imprecise wording and other flaws.

So we should keep this in mind and use some careful interpretation of what he's saying.

"At the moment, we should be anticipating that the returns on lending are going to start to look very good for banks, and they will lose interest in holding reserves, at which point we get some more serious inflation."

Maybe, but then why didn't this happen in Japan for 20 years and counting?

If I might put it this way; Krugman clearly favors more aggressive monetary policy. He wouldn't have written that column if he didn't. But I'm sure his reasoning is much more sophisticated than what's in that column. The column is to persuade the general public to support more aggressive monetary and fiscal policy, a general public with very little economics background. Plus, the New York Times limits him to about 350 words and will not keep him employed as a columnist if he doesn't make the column pretty crisp and entertaining to the general public. It can be very hard to write in a crisp, entertaining, "good style", way, with just 350 words, and still be highly technically accurate.

So, please keep that in mind, and remember it would be pretty hard to get tenure at MIT and Princeton, and a John Bates Clarke Medal and Nobel Prize, if your thinking was that sloppy.

Krugman wrote: "That vicious circle isn’t hypothetical: just ask the Japanese, who entered a deflationary trap in the 1990s and, despite occasional episodes of growth, still can’t get out. And it could happen here."

Direct response: "We're in the midst of what's looking like a strong recovery, and Krugman makes it sound like the midst of the Great Depression."

Wait a minute: Krugman says we *could* end up like Japan (a nation that has eked out a bit of net economic growth since he started writing about it), and you characterize that comment as sounding like we're *already* in the middle of the Great Depression? As if Krugman doesn't know the difference between 9% unemployment with a very low inflation rate, and the tragedy of 25% unemployment in a deflationary spiral?

You're not going to mount any credible critique of Krugman as The Great Exaggerator with this sort of strawman bashing. People will just take you for a hypocrite, if anything.

Krugman criticized the Bush administration, and rightly so, for lying to us in order to persuade us that going to Iraq was a good idea. Now, we are supposed to give Krugman the flexibility to exaggerate the facts and tell us a story without nuance, so that he can persuade lay people. Seems a little hypocritical, don't you think? Krugman is a well-trained economist with a Nobel prize, and two gifts: a big soap box - the New York Times - to speak from, and the ability to write clearly. I expect a lot more from him than what he is delivering.

This does not look like a strong recovery to me. A strong recovery generates hundreds of thousands of private sector jobs every month for years.

Additionally, a strong recovery increases the hours worked dramatically, and raises spending relentlessly.

I really, really like this blog. But you're just plain factually wrong about this recovery being strong.

Look at the absolute numbers for any indicators that are not based on sentiment. Look at tax receipts. Look at dollars spent, not increases. Heck, just look at GDP. 3% isn't strong growth. 5% is strong growth.

We are facing a very real danger of a double dip, Japanese style recession.